By Anthony Diosdi
Foreign investors often invest in the United States through financing. Foreign investors often utilize the portfolio interest exception to avoid the 30-percent flat tax on interest income. Planning for the portfolio interest exception is relatively simple, even if the investor is not from a treaty country. From the U.S. perspective, a foreign investor typically utilizes an offshore holding company in virtually all cases (except in cases where the foreign investor’s home country has meaningful restrictions on such holdings) and the foreign investor utilizes a “portfolio debt instrument to reduce or eliminate the 30-percent tax on interest income.
By way of background, in 1984, Congress repealed the 30 percent withholding tax imposed by Internal Revenue Code Section 871 and 881 with respect to certain interest paid on (non-effectively connected to U.S. trade or business) portfolio debt, referred to as “portfolio interest.” Portfolio interest refers to interest payments made to a foreign corporation (owning less than 10 percent of the payor entity) pursuant to debt obligations that are in registered form with appropriate certification. See IRC Section 881, IRC Section 163(f)(1). If the debt is not in registered form the interest does not qualify for the portfolio debt exemption. See IRC Section 871(h)(2); IRC Section 881(c)(2); Treas. Regt. Section 1.871-14; Notice 2012-20. Below, this article discusses the definition of “registered form” for purposes of the portfolio debt rules.
Definition of a Registration System
For purposes of determining whether a bond (portfolio debt instrument) is in registered form under Internal Revenue Code Section 163(f) and the portfolio interest exception, the principles of Internal; Revenue Code Section 149(a)(3) apply. Section 163(f)(3) and Section 149(a)(3) provide that a book entry bond is treated as in registration form if the right to the principal of, and stated interest on, the bond may be transferred only through a book entry consistent with the regulations prescribed by the IRS.
Treasury Regulation Section 1.871-14(c) provides that for purposes of the portfolio interest exception, the conditions for an obligation to be considered in registered form are identical to the conditions described in Section 5f. 103-1. Generally, under Section 5f. 103-1, an obligation is in registered form if:
(i) the obligation is registered as to both principal and any stated interest with the issuer (or its agent) and any transfer of the obligation may be affected only by surrender of the old obligation and reissuance to the issuer (or its agent) and any transfer of the obligation may be affected only by surrender of the old obligation and reissuance to the new holder;
(ii) The right to principal and stated interest with respect to the obligation may be transferred only through a book entry system maintained by the issuer or its agent; or
(iii) The obligation is registered as to both principal and stated interest with the issuer or its agent and can be transferred both surrender and reissuance and through a book entry system. An obligation is considered transferable through a book entry system if the ownership of an interest in the obligation is required to be reflected in a book entry, whether or not physical securities are issued. A “book entry” is a record of ownership, whether or not physical securities are issued. A “book entry” is a record of ownership that identifies the owner of an interest in the obligation. An obligation that would otherwise be considered to be in registered form is not considered to be in registered form as of a particular time if it can be converted at any time in the future into an obligation that is not in registered form. It should be noted that a book entry system is essentially an electronic system of tracking ownership of debt (bonds), securities, etc. No paper certificates are issued.
Example of How the Book Entry System Operates
The Commercial Book Entry System (“CBES”) is a multitiered automated system for purchasing, holding, and transferring marketable securities. CBES exists as a delivery versus payment system that provides for the simultaneous transfer of securities against the settlement of funds. At the top tier of SBES is the National Book Entry System (“NBES”), which is operated by the Federal Reserve Banks. For Treasury securities, the Federal Reserve operates NBES in their capacity as the fiscal agent of the U.S. Treasury. The Federal Reserve Banks maintain book entry accounts for depository institutions, the U.S. Treasury, foreign central banks, and most government sponsored enterprises or “GSEs.”
For purposes of the CBES rules, depository institutions hold book-entry accounts for their customers, which include brokers, dealers, institutional investors, and trusts. In the following tier, each broker, dealer, and financial institution maintains book-entry accounts for individual customers, corporations, and other entities. Thus, when an investor purchases securities through a broker, dealer, or financial institution, the securities are held on the book entry system of that firm
How Do Small Foreign Investors Comply With the Debt Registration Rules?
The above discussed registration form and book entry system requirements ensures tracking of the ownership of marketable securities or debt. The problem is a great deal of cross-border financing into the United States involves loans between two private parties. In these cases, it is virtually impossible to establish a registration or book entry system that would track ownership of the holder (i.e. Lender) of the debt.
In order to address the registration form requirements in the above discussed situation, a portfolio debt instrument or “Note” should include a provision that provides something to the effect of:
“Borrower shall keep a register of this Note as to both principal and any interest. Lender may transfer this Note, but such transfer may only be affected by surrender of this Note to the Borrower by the transferor Lender, and by issuance by the Borrower of a new Note with Identical terms (other than Lender, which shall be the transferred rather than the transferor). This registration requirement is intended to qualify the Note for portfolio-interest exemption of Internal Revenue Code Section 871(h)(2)(B) or Section 881(c)(2)(B), and shall be interpreted accordingly.”
This language is in the spirit of the registration requirement as it limits the transfer of the debt by one lender to the next lender through a surrender of an old obligation and the reissuance to a new holder. This proposed language also clearly states that the borrower will keep a register of the principal and interest with respect to the obligation stated in the note (This will obviously require the borrower to develop a system for tracking the payment of principal and interest to the Lender).
Conclusion
Portfolio debt can be a very useful U.S. tax planning tool where an investor does not qualify for the benefits of a tax treaty that eliminates withholding tax and where foreign source interest is not subject to income tax in an individual’s home country because interest paid on portfolio debt is completely exempt from U.S. federal tax. However, careful tax planning is necessary to not only avoid the U.S. withholding rules, but also to ensure interest payments on portfolio debt are deductible for U.S. tax purposes. In addition, a U.S. borrower involved in a portfolio debt transaction should receive a statement (usually on Form W-9) indicating that the beneficial owner of the obligation is not a U.S. person.
We have substantial experience advising clients ranging from small entrepreneurs to major multinational corporations in foreign tax planning and compliance. We have also provided assistance to many accounting and law firms (both large and small) in all areas of international taxation.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.
He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.